The Motley Fool, 6/17/97: The Evening News

SEDA SPECIALTY PACKAGING <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SSPC)") else Response.Write("(Nasdaq: SSPC)") end if %> gained $6 1/2 to $28 1/2 after the producer of specialty packaging for consumer products agreed to be acquired by CCL Industries for $29 per share in cash, which values SEDA at 2.6 times expected 1997 revenues and 19.2 times estimated 1997 EPS of $1.46. SEDA has grown earnings per share 33% per year since 1994, the year after it came public and stepped up capital investment with those IPO funds. That cash infusion allowed the company to increase its annual revenue growth rate from 32% to just under 40% over the ensuing two years. Despite a frumpy business description, last year SEDA generated a pre-tax profit margin of 17.9%, suggesting that growth and margins can be found in industries other than semiconductors and other neat-sounding things.

EQUIFAX INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EFX)") else Response.Write("(NYSE: EFX)") end if %> moved up $3 3/4 to $35 7/8 on news that Standard & Poor's will include the company in the S&P 500 Index, replacing PanEnergy, which is merging with DUKE POWER <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DUK)") else Response.Write("(NYSE: DUK)") end if %>. Part of the buying energy today came from short covering by those who have driven up short interest to a 10 days-to-cover level, which compares the number of shares currently sold short with the stock's average daily volume. Fear of the consumer credit cycle undoubtedly has something to do with this, and possibly those selling short are looking at the price/earnings ratio of 24 onestimated 1997 EPS. Like the merchant transaction processors, though, Equifax doesn't have direct exposure to consumer credit standards and could benefit from increased demand for credit information. In addition, Equifax is possibly one of the higher quality ways to participate the development and maturation of foreign economies.

Telco timing device maker DATUM <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DATM)") else Response.Write("(Nasdaq: DATM)") end if %> rose $4 1/2 to $31 1/4 after Hambrecht & Quist raised its rating on the company to "strong buy" from "buy," expecting that the company is having a good quarter with strong demand from such customers as LUCENT TECHNOLOGIES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LU)") else Response.Write("(NYSE: LU)") end if %> and MOTOROLA <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MOT)") else Response.Write("(NYSE: MOT)") end if %>. According to First Call estimates, analysts covering Lucent have been marking up their earnings estimates for the coming quarters. Analysts on Motorola have been in more of a "show me" mode. According to Dow Jones, the analyst covering Datum said its relationship with both of these major customers "continue[s] to be strong, and [that] the company is well positioned against its competition."

DELL COMPUTER <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %> rose another $5 1/2 to $120 7/8 after the company's comments Monday that it was "very pleased'' how its fiscal second quarter was shaping up and that momentum in Europe was continuing. Many other computer-related companies have been facing slowing sales in Europe, but for the most part these have been software companies that focus on large businesses. Merrill Lynch analyst Lucianne Painter made positive comments on COMPAQ COMPUTER <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CPQ)") else Response.Write("(NYSE: CPQ)") end if %>, which helped matters. Hard drive manufacturer WESTERN DIGITAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WDC)") else Response.Write("(NYSE: WDC)") end if %> rose $2 3/8 to $33 3/8, possibly benefiting from the comments by Dell, as it is a large customer. Disk drive head manufacturer APPLIED MAGNETICS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: APM)") else Response.Write("(NYSE: APM)") end if %> also jumped $3 to $25 7/8.

QUICK TAKES: Computer telephony integration company GENESYS TELECOMMUNICATIONS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: GCTI)") else Response.Write("(Nasdaq: GCTI)") end if %> gained $9 1/2 from its IPO price of $18 to close at $27 1/2... Antenna measurement systems manufacturer ORBIT/FR INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ORFR)") else Response.Write("(Nasdaq: ORFR)") end if %> closed the day at $10 3/8, up $2 1/8 from its IPO price of $8 1/4... ELECTRICIDADE DE PORTUGAL SA <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EDP)") else Response.Write("(NYSE: EDP)") end if %> gained $8 3/4 to $34 1/2 after the Portuguese utility company went through its first round of privatization when shares were sold yesterday to institutional investors at $25.84... GENOVESE DRUG STORES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GDX.A)") else Response.Write("(NYSE: GDX.A)") end if %> added $2 1/4 to $21 5/8 on takeover rumors inspired by recent industry consolidation, according to Dow Jones... Energy services company WILBROS GROUP <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WG)") else Response.Write("(NYSE: WG)") end if %> added another $1 3/8 to $15 after yesterday announcing a $100 million in new orders in Africa, Asia, and South America... IOMEGA CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IOM)") else Response.Write("(NYSE: IOM)") end if %> gained $1 7/8 to $22 3/8 on announcing a 10 gigabyte tape drive, the Ditto Max, expected to be priced at $299... Prison company WACKENHUT CORRECTIONS CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WHC)") else Response.Write("(NYSE: WHC)") end if %> rose $1 5/8 to $23 1/4 after winning a contract to design, build, and run a 480 bed juvenile facility for the State of Michigan... Shipping company OVERSEAS SHIPHOLDING GROUP <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OSG)") else Response.Write("(NYSE: OSG)") end if %> picked up $1 3/8 to $20 1/8 on announcing an agreement with a partner to sell Celebrity Cruise Lines to ROYAL CARIBBEAN CRUISES LTD. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RCL)") else Response.Write("(NYSE: RCL)") end if %> for $230 million in cash and 7.4 million Royal Caribbean shares... Bermuda reinsurance concern EXEL LTD. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: XL)") else Response.Write("(NYSE: XL)") end if %> moved $3 1/2 higher to $52 1/2 after reporting Q2 EPS of $2.46, up from $0.95 last year. European electronics giant PHILIPS ELECTRONICS NV <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PHG)") else Response.Write("(NYSE: PHG)") end if %> gained $3 to $66 1/4 after announcing a $2.5 billion joint venture with LUCENT TECHNOLOGIES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LU)") else Response.Write("(NYSE: LU)") end if %> to produce corded and cordless phones, other wireless devices, and answering machines... Energy exploration and production firm MCFARLAND ENERGY <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MCFE)") else Response.Write("(Nasdaq: MCFE)") end if %> tacked on another $1 3/4 to $18 3/8 after yesterday's unexplained $3 3/8 move on releasing news this morning that it will be acquired by MONTEREY RESOURCES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MRC)") else Response.Write("(NYSE: MRC)") end if %> for $18.55 per share in cash... COUNTRYWIDE CREDIT INDUSTRIES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CCR)") else Response.Write("(NYSE: CCR)") end if %> added $1 7/8 to $33 3/8 after the mortgage lender reported Q1 EPS of $0.64, in line with the range of First Call estimates.

COMPLETE BUSINESS SOLUTIONS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CBSL)") else Response.Write("(Nasdaq: CBSL)") end if %> lost $1 1/2 to $24 1/4 after Donaldson, Lufkin & Jenrette cut its rating on the company to "market perform" from "buy," despite the company's announcement yesterday that it signed a Year 2000 remediation contract with South Carolina Electric & Gas. Unlike some hype-driven stocks involved in the Year 2000 problem, Complete Business Solutions has a substantial business in information technology solutions and has put together a Year 2000 marketing alliance with enterprise management software company PEOPLESOFT <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PSFT)") else Response.Write("(Nasdaq: PSFT)") end if %>. The other part of the Year 2000 problem that plays into the hands of a systems integrator such as Complete Business Solutions is that a company may choose to totally migrate to new millennium-compliant software on new hardware platforms. Complete Business Solutions would probably be only too happy to cannibalize its Year 2000 group's sales with that sort of business.

REYNOLDS & REYNOLDS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: REY)") else Response.Write("(NYSE: REY)") end if %> dropped $4 to $15 3/4 after the application developer and business forms company issued an earnings warning today, saying it will record Q3 EPS of $0.21 to $0.25, below estimates of $0.33. The company's bread and butter is the auto industry, where it sells enterprise management software to better than 90% of the franchised dealerships in the country. Reynolds said that dealerships were tentative about buying because of lagging sales and labor strike problems in automobile manufacturing, but that revenues will still grow 17% year-over-year. Another possible reason why the stock was down so sharply was the company's concurrent announcement that it has acquired two healthcare information systems vendors, adding to the company's presence in healthcare information management. Information on R&R's healthcare information efforts is scanty, leaving the research door wide open for those willing to do some digging on the company's efforts in that area.

QUICK CUTS: WEST TELESERVICES CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: WTSC)") else Response.Write("(Nasdaq: WTSC)") end if %> lost $3 3/16 to $12 9/16, though the call center outsourcing company said it is comfortable with Q2 estimates of $0.13... PRIME CAPITAL CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PMCP)") else Response.Write("(Nasdaq: PMCP)") end if %> declined $1 1/4 to $5 1/4 after filing a lawsuit that reveals that leases it owns are currently in default... Medical products company VITAL SIGNS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: VITL)") else Response.Write("(Nasdaq: VITL)") end if %> slumped $2 3/8 to $18 3/4 after the company said it will acquire respiratory products maker Marquest Medical, which the company says will necessitate an expansion of its sales force and will hurt near-term earnings... Canadian plumbing and building products company EMCO LTD. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: EMLTF)") else Response.Write("(Nasdaq: EMLTF)") end if %> lost $1 1/8 to $11 1/8 after the company said it will issue $75 million in debt... AMWAY JAPAN LTD. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AJL)") else Response.Write("(NYSE: AJL)") end if %> lost $2 3/8 to $16 7/8 after the consumer products marketer said it expects fiscal 1997 sales to fall 4.8% and earnings to decline 16.7%, both in yen terms... GATEWAY 2000 <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GTW)") else Response.Write("(NYSE: GTW)") end if %> lost $3 9/16 to $30 9/16 before being halted on the Pacific Stock Exchange. The company said revenues will come in lower than expected and that operating costs will be higher than forecast... Fashion designer TOMMY HILFIGER CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TOM)") else Response.Write("(NYSE: TOM)") end if %> slid $3 1/4 to $40 1/8 after Dillon Read cut its rating on the company to "outperform" from "buy"... FILA HOLDINGS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FLH)") else Response.Write("(NYSE: FLH)") end if %> declined another $2 3/8 to $30 1/2 after yesterday's profit warning... UCAR INTERNATIONAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UCR)") else Response.Write("(NYSE: UCR)") end if %> slid $3 1/8 to $41 after the company said its customers have filed a class action lawsuit against the graphite electrode company alleging price fixing. Recently, UCAR and other industry participants were slapped with grand jury subpoenas.

Understanding what really goes into the deceptively simple number known as return on equity (ROE), the measure becomes a lens through which to analyze a company. Return on equity is a combination of profit margin, asset management and financial leverage. Breaking return on equity into these component parts not only allows the investor to determine what the kind of return on equity is being generated by a company, but also to examine the quality of that return as well as which financial levers management is pulling to create it. In fact, this way of looking at return on equity creates a system of ratios that allows the individual investor to really understand how the basic business is being managed.

USA DETERGENTS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: USAD)") else Response.Write("(Nasdaq: USAD)") end if %> represents an excellent example of how analyzing the components of the return on equity equation would have led an investor to radically different conclusions than by simply looking at the ROE number by itself. In 1996, USA Detergents generated a return on equity of 21.5%. Although strikingly high for a detergent company, it was down from 34.6% in 1995 and 72.6% in 1994. Looking at the 10-K, an investor would have been left to answer the riddle of why the return on equity had been declining so rapidly over the past twelve months and what it foretold for the company's stock.

The first part of the ROE analysis is to look at the profit margin. USA Detergents had sales of $68.7 million in 1994, $104.9 million in 1995, and $174.0 million in 1996. The company earned profits of $4.3 million in 1994, $7.0 million in 1995, and $8.9 million in 1996. As profit margin is simply earnings divided by revenues, this means that the profit margin over that three-year period went from 6.3% in 1994 to 6.7% in 1995 and finally dropped to 5.1% in 1996. The first impression is that USA Detergents is not a very high margin business. The company makes commodity, value-priced laundry detergents under brand names with questionable staying power, an impression confirmed by the margin. We can determine initially that the high returns on equity certainly are not coming from high profit margins.

Although the drop in ROE could from 1994 to 1995 did not come as a result of falling margins, in the the slip from 1995 to 1996 profit margin certainly contributed and is worth exploring further. To do this, we would next look at the company's operating margin, a ratio of the operating earnings to the revenues. Operating earnings tell you how the company's operations were doing, outside of the effect of changes in tax liability or interest payments. For USA Detergents, operating earnings in 1995 were $9.7 million and $15.7 million in 1996, meaning that operating margins increased from 9.3% to 9.9% over the period. A quick look at the tax rate identifies the culprit, as from 1995 to 1996 the tax rate jumped from 23% to 40%, taking a nice whack off the top of the profit margins. Otherwise, operating earnings actually improved.

Since profit margin or any other ratios from the income statement do not really explain the shortfall, we next move to the left side of the balance sheet, or the assets. Asset turns is simply sales over total assets. As USA Detergents had $24.5 million in assets in 1994, $40.6 million in assets in 1995, and $98.9 million in assets in 1996, we can immediately see that assets were growing faster than sales. Asset turnover in 1994 was 2.8 times, in 1995 was 2.6 times, and in 1996 plummeted to only 1.8 times. Looking deeper into the asset side of the balance sheet, the huge build up in inventories and accounts receivable seem to be the cause. Inventory turns (cost of goods sold divided by average inventory over the year) dropped from 8.7 to only 4.3, given that the company had $8.5 million in inventories in 1995 and $27.0 million in 1996. Days sales outstanding (365 divided by sales over accounts receivable) also rose from 53 to 59.

Both lower inventory turns and higher days sales outstanding meant that although the company was booking plenty of sales, it was building up cash-sucking inventories faster, and it was not as efficient at collecting money from its sales. A classic problem with small companies, USA Detergents appeared to be literally "growing" broke as working capital needs consumed more and more of its profits. Faced with mounting working capital needs and pretty flat income from operations, management at USA Detergents was left with only one financial lever to try to generate more earnings out of its basic business -- turning up the financial leverage.

Turning to the right side of the balance sheet, or liabilities, we see that long-term debt increased from $1.8 million in 1995 to $30.8 million 1996. With stockholder's equity of $20.3 million in 1995 and $41.3 million in 1996, this meant that the debt-to-equity ratio jumped from 8.9% in 1995 to 74.6% in 1996, a pretty massive leap. Debt-to-total equity (debt plus equity) climbed from 8.1% to 37.3%, a sizable leap but not necessarily the same magnitude. Any one of the of half-a-hundred other ways to compare debt to some other part of the company's balance sheet shows the same conclusion -- debt as a portion of equity increased dramatically in 1996 as the company struggled to meet working capital needs and maintain its earnings.

Although in 1996 the times interest covered (earnings before interest and taxes divided by interest expense) was still 18 times given that interest expense was $0.9 million, the fact that asset management was deteriorating and causing the company to become increasingly debt financed increased the risk. Most investors know that shortly after the year-end statements were reported, USA Detergents' stock price fell from the mid-$20s to the current perch at $12 and change when the company missed earnings expectations.

A visual way to think about the analytical process we just went through would look like this:

                   Return on Equity
                          !
   (Income)           (Assets)           (Liabilities)
   ----------------- -----!-----------------------------
      !                   !                    !
  Profit Margin     Asset Turnover      Financial Leverage
      !                   !                    !
Operating Margin    Inventory Turns      Debt-to-Whatever
      !                   !                    !
  Gross Margin      Days Sales Out.   Times Interest Earned

By looking at trends in return on equity and analyzing the components, the investor is forced to not only examine the much overlooked Statement of Operations, or the Income Statement, but also to balance this against the left and right sides of the Balance Sheet.

MICRON TECHNOLOGY <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MU)") else Response.Write("(NYSE: MU)") end if %>
(402) 220-1003 -- replay

ORACLE CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ORCL)") else Response.Write("(Nasdaq: ORCL)") end if %>
(402) 220-4217 -- replay available from 8 p.m. EDT until 6/18

06/18/97 (Wednesday)
ADOBE SYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ADBE)") else Response.Write("(Nasdaq: ADBE)") end if %>
after 8:45 p.m. EDT for 3 days
(800) 633-8284 (reservation # 2805001)

06/19/97 (Thursday)
BRODERBUND SOFTWARE <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BROD)") else Response.Write("(Nasdaq: BROD)") end if %>
(800) 642-1687 (ID#427430) -- replay available through 6/23

True, true, the Daily Double is available for free every day at the Fool. But did you know that for only peanuts (well, actually FoolMart doesn't accept peanuts), we'll e-mail it directly to you? No more having to remember to read it -- it will simply be there, waiting for you, shortly after market close. Give it a try -- for a limited time only, we're offering free two-week e-mail subscriptions to the Daily Double, which introduces you each day to a stock that has doubled in the past six months. There's no obligation, so tell your friends about it, too. To sign up for the free trial, simply send an e-mail to [email protected] and request the Daily Double free trial.